Good morning. My name is Chad, and I will be your conference operator today. At this time, I would like to welcome everyone to the Novanta Incorporated 2017 Q4 Earnings Call. All lines have been placed on mute to prevent any background noise. Please note that this call is being recorded. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions]. It is now my pleasure to hand the conference over to Mr. Ray Nash, Corporate Finance Leader. Please go ahead sir.

Thank you very much. Good morning, and welcome to Novanta’s fourth quarter 2017 earnings conference call. I’m Ray Nash, Corporate Finance Leader of Novanta. With me on today’s call is our Chief Executive Officer, Matthijs Glastra; and our Chief Financial Officer, Robert Buckley. If you’ve not received a copy of our earnings press release issued today, you may obtain it from the Investor Relations section of our website at www.novanta.com. Please note this call is being webcast live and will be archived on our website shortly after the live call. Before we begin, we need to remind everyone of the Safe Harbor for forward-looking statements that we’ve outlined in our earnings press release issued earlier today, and also those in our SEC filings. We may make some comments today, both in our prepared remarks and in our responses to questions that may include forward-looking statements. These involve inherent assumptions with known and unknown risks and other factors that could cause our future results to differ materially from our current expectations. Any forward-looking statements made today, represent our views only as of this time. We disclaim any obligation to update forward-looking statements in the future, even if our estimates change. So you should not rely on any of these forward-looking statements as representing our views as of any time after this call. During this call, we will be referring to certain non-GAAP financial measures. A reconciliation of such non-GAAP financial measures to the most directly comparable GAAP measures is available as an attachment to our earnings press release. To the extent that we use non-GAAP financial measures during this call that are not reconciled to GAAP measures in the earnings press release, we will provide reconciliations promptly on the Investor Relations section of our website after this call. I’m now pleased to introduce the Chief Executive Officer of Novanta, Matthijs Glastra.

Thank you, Ray. Good morning everybody and thanks for joining our call. I’m going to start with a brief overview of 2017 and what we expect to see in 2018. 2017 was a defining year for Novanta with strong, strategic execution and fantastic financial results. Our company delivered $521 million in full year 2017 revenue, representing 35% year-on-year growth and over 8% organic revenue growth. Our full year book-to-bill was 1.05. In addition, we expanded our full year EBITDA margins year-over-year by 260 basis points to 20.3% of sales. Adjusted EBITDA was $106 million, which is up 55% versus 2016. Our full year adjusted earnings per share was $1.60, which was up 47% versus the prior year. At Novanta, our mission is to deliver innovation that matters, providing mission-critical functionality to our medical and advanced industry OEM customers while improving productivity and enhancing people’s lives for end-users. We want to be the trusted technology partner for our OEM customers where we provide a differentiated technology solutions in long life cycle customer platforms. We believe that the strength of our team, our robust business model in diversified applications with a balanced exposure to medical and industrial markets are serving us well. Two years ago, we set our 2020 strategic direction of doubling our company to $750 million in revenue with more than 50% of our revenue in medical markets, growing 5% to 7% organically per year with an adjusted EBITDA margin of 20%. In 2017, we made an important step towards that ambition, tracking well in terms of growth and profitability while ending the year at a run rate of over 50% of our revenue from medical markets. Our organic revenue growth accelerated to over 8% as a result of increased exposure to growth markets, new product introductions and commercial execution…

Thank you, Matthijs. Good morning everyone. We delivered $146.9 million in revenue in the fourth quarter of 2017, an increase of 48.6% on a reported basis. The net effect of our acquisitions and divestitures resulted in an increase in revenue of $39.1 million or 39.5%. Whereas, foreign currency exchange rates favorably impacted our revenue by 800,000 or 0.8%. Consequently, organic growth was 8.3% year-over-year in the fourth quarter. For the full year 2017, we generated $521.3 million in revenue, an increase of 35% on a reported basis, and organic growth was positive 8.5% year-over-year. Reported revenue was in line with our expectations and our organic revenue growth finished off the year slightly stronger than anticipated as explained earlier by Matthijs. Fourth quarter 2017 GAAP gross profit was $62.2 million or 42.4% of sales. This compares to $42.9 million or 43.3% of sales in the fourth quarter of 2016. Full year 2017 GAAP gross profit was $220.5 million or 42.3% of sales, this compared to $162.5 million or 42.2% of sales in 2016. Included in gross profits for 2017 with the impact of $8.8 million or 1.7% of sales of amortization of purchased intangible assets compared to $4.2 million in the prior year. On a non-GAAP basis, fourth quarter 2017 adjusted gross profit was $65 million or 44.2% of sales compared to $43.9 million or 44.3% in the fourth quarter of 2016. Full year 2017 adjusted gross profit was $234 million or 44.9% of sales, compared to $168 million or 43.7% of sales in 2016, representing a 120 basis point improvement in gross margins year-over-year. Overall, our gross margins for the full year expanded in line with our expectations communicated back in January of 2017. But it is fair to say, we did not achieve this in the manner we hoped…

Thank you. We will now begin the question-and-answer session. [Operator Instructions] First question will come from Lee Jagoda with CJS Securities. Please go ahead.

Good morning, its Pete Lucas for Lee. Just one, thinking about M&A. what – going forward, what capabilities do you think are still either below where you want them to be or missing in terms of what we believe it’s important to customers as they design new products?

Yes, good morning. I don’t think we’ve specified specific directions or targets. I mean, we’ve highlighted our overall strategic direction of being a mission-critical technology provider for medical and advanced industrial applications in markets based on our capabilities and Photonics and Precision Motion and Vision technology. So you can expect us to play in that field in order to adjacent acquisitions that expand our market exposure into growth markets or our technology buildings that adds to our technology capabilities.

Great, thanks. And just one more from me. You talked about overall gross margins but looking at gross margins for Vision specifically, just wondering, yes, I think you touched on it briefly what the headwinds were there and how quickly it can get back to where it had been running?

Yes. A large chunk of that was associated with WOM and that’s related to the growth in the disposable business. It’s something that we have projected early on would have an impact. It was a little bit higher-than-expected as a consequence of launch of some new more sophisticated tube sets. That something that will normalize little bit more as we get into 2018, so we should see some improvements there. But the step function change in the gross margin profile is something that’s projected to be out in the 2020 time horizon, largely as a consequence of their FDA regulated environment causes and qualification processes need to be followed as we improved their operations and drive improvements in that consumable manufacturing process.

Very helpful. Thanks, I’ll get back in queue.

The next question will be from Richard Eastman with Robert W. Baird. Please go ahead.

Hi, good morning. Just to clarify your answer on the last question. So the suggestion is that with revenue in Vision relatively flat quarter-to-quarter and a decline of $2 million in gross margin. That is the function of WOM’s kind of a new launch on the disposables? Is that kind of what you were…

Yes, it’s a combination of higher disposables revenue as a proportion of the overall revenue as well as the launch of some new disposables. So it’s a combination of two kind of events there. It is – I think we’ve talked about in the past. The disposable revenue is significantly lower than the capital equipment. So there are mixed shift between those then you see the consequences of that. And then, that coupled with the new launch drove it a little bit lower. So that mixed shift will improve as we get into 2018. And so the margin – gross margin profile will improve in 2018. But the step function change and the profitability gross margin profile disposables won’t change until we set up the manufacturing process.

Sure. Okay, understood. And then also just a question around the gross margin on Precision Motion. Again, kind of steady revenue quarter-to-quarter, we did absorb apparently some Celera Motion kind of cost, the supply chain issue cost. But it’s not terribly apparent in the gross margin dollars or percentage with the revenue quarter-to-quarter. Is that perhaps Westwind delivering some upside to the gross margin line?

No.

No? Okay.

No. The offset surprisingly is actually on the balance sheet. So we took inventory up to eliminate some of the cost before quality, right. So effectively, we brought in more inventory to increase the efficiency of our production processes. So we didn’t have the same labor and efficiencies and that we can sort through any sort of bad inventory or late deliveries. So that’s how we offset it. It’s one of the ways we’re mitigating and that’s why the net working capital as a percentage of revenue had climbed.

I see, okay, okay. So to normalize as we get into the mid-part of 2018, do we return to 47%, 48% or again is a 45% gross margin there somewhat normalized now given the inventory, safety start?

The margin profile is somewhat normalized for now and so we worked through the supply chain issues on a permanent basis. So all we’ve really done is file for some of the temporary inefficiencies. We have actually solved the supply chain issues themselves by buying a lot of inventory, you just kind of putting a Band-Aid on there. So we’ll work our way through that sale and that something is expected to be a little bit of headwind in 2018, but we’ll – we have confidence so we can do it. We know exactly what’s going on here and how to fix it, and we’ve demonstrated that in Photonics segment.

Okay. And, Matthijs, just a quick question for you. Around the 2020 targets, we ended calendar 2017 at above 20.3% EBITDA margin, adjusted EBITDA margin. And I’m curious if you could kind of reconcile maybe the 20% target out to 2020. Is the thought here in that the core can run ahead of 20%? And then we’re leaving some cushion there for any dilution from acquisitions. Is that the best to reconcile where we’re today versus where we’re headed?

Yes, Rick, that’s a good way to look at it. Basically, what you’ve seen with the WOM acquisition, for example, is that acquisitions, we feel could be dilutive to that 20%. And therefore, we feel it’s prudent, yes, to consider a blend of acquisition effects as well as core contribution. I’ll also argue that we continued to invest in innovation and commercial teams. So there is also an organic growth investment component to that. So combined, all these things combined, Rick, we feel good where we’re at right now with that 20%, and, yes, will not see us kind of making any changes to that number in 2020.

Okay. Just one thing for 2018 – calendar 2018. Again, we’re kind of focused on guiding roughly towards this 5% to 7% core growth rate. With the – in the Vision segment, with the – maybe the headwinds around JADAK and diabetes business, for all of 2018, does Vision grow core in the low-single digits or mid-single digits? Or how do you see that business shaping up for all of 2018?

Yes, we’re not going to provide guidance for operating segment rate on core growth. What we have commented on is, is that one of the reasons why there was a decline in that segment in the fourth quarter was because of the dynamics that you have highlighted. We feel that by the second half of 2018 those headwinds will have subsided. And therefore, we will turn back to growth in the detection and analysis business reported NDS to be a positive contributor to both profits and growth for the full year. And we have also commented that WOM will actually – will be fighting some tough comps, right, because WOM will become core growth in the second half of the year of a very strong second half of 2017. That’s a temporary situation. As we also have commented that we’re very confident and feel very pleased with the quality of that business and its long-term growth prospects. So that’s how you need to think about it.

Okay, fair enough, and very nice finish to 2017. Thanks, guys.

Thank you, Rick.

The next question will be from Brian Drab with William Blair. Please go ahead.

Good morning, thanks for taking my questions. First question just on the organic revenue growth; I think you talked about that a little bit further. So the guidance has 8% in the first quarter, then talk a little bit about the tough comps and dynamics later in the year. But is there anything more specific you could tell us as we’re trying to think about modeling the quarterly progression of organic revenue growth? Because the full year guidance, I think implies about 4%, which would taken all these data points into account that 8% in the first quarter around 4% for the full year. We’re going to have some quarters that I guess, are the math below 4% or flat in 2018?

Well, the organic growth profile depends on which growth profile you’re talking about. For the full year, the guidance is 5% to 7% organically, and that excludes the acquisitions and excludes the foreign exchange rates. If you look at the first half, obviously, is 7.5% – our first quarter is in the 7.5% to 8.5% range. The second quarter is will be a little robust as well. And in the back half of the year, it will be a little less robust, but for the full year you’re still on that 5% to 7% range.

Okay, got it. That’s just my math and I was coming in a little bit below 5%, but I’ve got it. For the full year, 5% to 7%, okay. And then are you seeing any pent-up demand as a result of this supply change challenges? And how does that play out in 2018? Is there a tailwind early in the year potentially? And then also conversely is there any damage potentially to customer relationships as a result of any delays with these issues?

No, we’re not modeling or forecasting any positive pent-up demand or any negative consequences at this stage. I mean, like we said, we feel we can serve our customers needs right now in the Precision Motion business where we commented on. I think on the Cambridge Technology side where we’ve commended on supply chain challenges in the past, we have come out of it very nicely. And so that team is humming very nicely. So we don’t see any issues there. So those are the two businesses where we’ve commented on supply chain challenges and, yes, there is no impact of that towards our guidance probably.

One of the things I’d add to that is that, as many of you know, there’s continuous improvement culture here, specifically applied around lean principles and our manufacturing footprint. And one of the principal elements of that is that you don’t let the cost of poor quality escape to your customers, which is why that really results in our gross margins is taking the larger hit. But you try to maintain the relationships with your customers while observing the cost of poor quality in-house. The purchase of additional inventories helps to mitigate that a little bit, but it doesn’t resolve the fundamental issues. So we have been protecting our customers as best we can from some of these issues. And I think we’re pretty successful in doing that. But that’s really what’s causing the swing in the gross margins.

Okay, great. Thanks. And then, speaking of gross margins, you talked about the 100 basis point expected improvement in 2018. What is the main source of that improvement in 2018? Is it the resolution of the supply chain issues? Is it mix? Or is it productivity improvements in the factories? How do you rank order that?

Yes, I’d rank that as first and foremost just resolve the supply chain issues. And so it is without a doubt, you’ll get a little bit of a pickup in the businesses that had supply chain issues in the past, there will be drivers of our productivity engine in 2018. So what we’re expecting in Cambridge and our Celera Motion to really kind of step up.

Okay. And then, just two more quick ones on pricing. In the past, pricing hasn’t really been a component of your revenue growth. And I understand why given customer relationships et cetera. We’re in an environment of rising rates, inflation, or material prices. Is there possibility that the price increases would contribute to revenue growth in 2018?

Well, we’re continuously looking at price and particularly of new products, right. So that’s the area where continuous – see us continues looking. We’re very carefully and thoughtfully looking at our supply chain at this moment, we don’t see any major issues. But if those would arise, then we’ll definitely take action. So it’s not an explicit part of our forecast at this stage. But to me this is business as usual. You got to match as these things come up. And rest assured that things from a strategic and structural perspective, we’re looking at our innovations of course to expand revenue but to also expand margins.

Okay, thanks. And then last one just SG&A. I just missed the comment Robert that you made. Did you say flat in 2018 or how should we think about SG&A in terms of dollars as we progress?

I said flat on a percent of sales basis with the guidance that we provided. So think about it more – broad on a percent of sales basis. It will change because it’s in our second half – is in our full year results now versus in prior periods it was not.

Okay. So for the full year you think about it as flat year-over-year roughly in terms of percentage of sales?

That’s correct.

Okay, got it. Thanks a lot.

The main change in operating expenses, the R&D going from $8 million to $9 million.

Got it. Okay, thank you.

[Operator Instructions] The next question comes from Mark Larry with Sandhill Investment Management. Please go ahead.

Good morning, guys. Questions on the fragmented markets in Precision Motion that you had alluded to. Just curious to have some color on your ability to take share there and perhaps how quickly that could happen?

Yes. I mean, the Precision Motion market is fairly large market, where we play in the real high precision niche part of that market. But we’re not playing in all the segments. And typically those segments are represented by the few players only. So therefore, the reason for commenting on this is that we feel this is an attractive space, it’s still growing because of the trends that we have highlighted. And yes, competition is fragmented and focused on particular segments. So we’re looking at both organically expanding our served markets as well as through acquisitions. And given our results, you can kind of see what we have been doing pretty well at that. Yes, so we’re optimistic about this space, which we feel is attractive. And so that’s why we’re ramping up our investments. And yes, you’ll see us continue to make moves in this space.

Okay, great, thanks. And then one more in terms of 50% of sales now in medical. Give us a sense of what portion of that business is on the consumable, disposable side?

Well, the easy math is, it was 40% of WOM at the time that we bought it. And that was EUR80 million business. So that would be kind of the easy math around it. It’s obviously grown a little bit in the back half of the year. But things of that dynamics around that will change a little bit as we get into 2018, where we got launch of more capital equipment, the insufflators themselves. So think about this 40% of the EUR80 million.

Okay. And the rest of medical is there any sense of consumables or recurring revenues sales there?

No. Everything else we do is a technology solution that gets sold into a piece of capital equipment. There is an aftermarket element of that of course, but we can’t see that, as we’re really kind of part of the supply chain of our customers. We agree that they are replacing parts in the aftermarket basis. To us it just looks like part of the combo system. So we don’t have visibility into that.

Okay, great. Thank you, guys.

And there are no further audio questions. I’d now like to hand the conference back to Mr. Matthijs Glastra for any closing remarks.

Thank you. So to summarize, 2017 was a fantastic year for Novanta. Our focus on accelerating profitable growth and a diversity and the strength of our businesses was evident in our strong financial results. We’re well on our way in executing our 2020 strategic direction to double the company in revenue to $750 million with 20% EBITDA margin, growing organically 5% to 7% while generating more than 50% of our revenue for medical markets. Our growth strategy is focused on multiple growth drivers, relentless focus on establishing leading market positions in growth markets, expansion of our served markets through innovation and disciplined M&A, which focus on expanding our medical presence, deeper market penetration globally through a stronger and larger commercial team, and all of this while maintaining our commitment to discipline execution and continuous improvement. In closing, I’d like to thank our customers, our employees and our shareholders for their ongoing support. We appreciate your interest in the company and your participation in today’s call. I look forward to joining all of you in several months on our first quarter earnings call. Thank you very much. This call is now adjourned.

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.